Rogue (Goldman) Algo Exposes Cracks In The Options Market

Just three weeks ago, Goldman Sachs cried 'uncle' when their market-making options algo-machine exploded in a fit of guilt causing the firm to face hundreds of millions of dollars losses (should the exchange not have DK'd the deals). Nanex has investigated the rogue algo and here are the findings... "As soon as option quotes in the affected symbols began exceeding theoretic economic values by some threshold, quotes (and therefore liquidity) on other options exchanges for those contracts would immediately disappear - bid/ask prices would go to zero at other exchanges. Within 10 seconds of starting, one algo, in effect, completely destroyed the concept of the National Market System and obliterated liquidity..."

As they sadly conclude, what was the fine for shutting down an options exchange, and destroying liquidity in hundreds if not thousands of options contracts? There was no fine. Worse, they were able to get the trades busted. As in, pretend we didn't just do that. Pretty shocking. Until there are financial consequences for firms that turn on market disrupting algos, the markets, will continue to be disrupted.

Shortly after market open (9:30 ET) on August 20, 2013, a rogue High Frequency Trading (HFT) algo appeared in the U.S. options market and began affecting both options and stocks. The algo placed orders to sell up to 1000 option contracts on stocks with symbols beginning with the letters IE through KIM. The sell orders were placed on the AMEX options exchange with a limit price that started out high, and over the next minute, ratcheted down one penny at a time to $1: regardless of the strike or value of the underlying stock or ETF. The sell order sizes started at 1000 contracts and only decreased when buy orders executed against them. The algo didn't appear to take into account higher bid prices on the other options exchanges - because when it lowered the sell price, it often caused the NBBO (National Best Bid/Offer) to lock (bid = ask) or cross (bid > ask).

As soon as option quotes in the affected symbols began exceeding theoretic economic values by some threshold, quotes (and therefore liquidity) on other options exchanges for those contracts would immediately disappear - bid/ask prices would go to zero at other exchanges.

Within 10 seconds of starting, one algo, in effect, completely destroyed the concept of the National Market System and obliterated liquidity.

At 9:36:37.551, options quotes ceased from the AMEX exchange in all options, not just those affected by the algo. Maybe the firm responsible for the algo thought it was AMEX's fault, or maybe AMEX noticed a large number of crossed option quotes and took action. Regardless of the cause, the outage lasted 13 minutes.

It was later reported that the algo was run by Goldman Sachs. What was the fine for shutting down an options exchange, and destroying liquidity in hundreds if not thousands of options contracts?

There was no fine. Worse, they were able to get the trades busted.

As in, pretend we didn't just do that. Pretty shocking.

Until there are financial consequences for firms that turn on market disrupting algos, the markets, will continue to be distrupted.

Update: September 11, 2013.

Looking closer at the data from the AMEX options exchange just before it went offline (chart 9 below), we find a series of quote blasts starting at 9:36:33.979 and continuing until the exchange went dark at 9:36:37.551. These messages are comprised of quotes with zero bids and asks which are used to clear out an exchange's quotes from downstream systems (quote terminals and the like), and maintain the integrity of the NBBO. The presence of these messages indicates that this was a planned, orderly shutdown.

Did AMEX prevent a repeat of the Knight Capital Meltdown by pulling the plug?

We have to wonder: did the firm that ran the rogue algo ask AMEX to shut down because they couldn't figure out what was wrong or how to shut the algo off themselves? Or was the exchange being proactive and shutting down just in case they had another Knight Capital like meltdown on their hands? Is this the first known use of a kill switch? A bit overkill (only one firm needed to be killed, not the entire exchange), but given Wall Streets recent technology failures, this was a prudent decision.

List of several, large, well known symbols with a significant aberration in option prices:

Symbol

Name

Market Cap ($Billions)

IWM

Russell 2000 ETF

(Assets) 25

JPM

JP Morgan

200

IMO

Imperial Oil

36

K

Kellogg

22

KIM

Kimco Realty

8

JOY

Joy Global

6

JLL

Jones Lang Lasalle

4

IT

Garnter

5

IEX

IDEX

5

KBR

KBR

5

JOE

The St. Joe Company

2

1. All IWM Options Contracts: Ask prices color coded by reporting exchange. Chart shows about 5 minutes of trading.Multiple lines of gold triangles representing ask prices from AMEX descend towards $1: these are from the rogue algo. The triangles form lines: one line for each option contract the algo was selling.

2. IWM September 2013 96 Call - Showing all bid and ask prices color coded by exchange and NBBO over about 2 minutes of trading.Note the line of gold triangles descending towards $1. These are ask prices from the rogue algo. It is one of the strings of diamonds from Chart 1 above.

3. IWM September 2013 96 Call - Showing trades and NBBO.The large gold dot is from one trade of 933 contracts.

5. IWM September 2013 96 Call - Showing best bid and ask prices color coded by exchange and NBBO. Zoomed out in time from Chart 4 above.Note how the NBBO spread remained exceptionally wide (over $4) for many minutes after the rogue algo stopped. The spread temporarily narrowed right after the AMEX Options Exchange was halted.

6. Message rates for each of the 48 multicast lines that carry option data. The bottom panel shows a count of crossed NBBO quotes by multicast line. Lines 21-24 carry traffic for symbols IE - KLZ and are colored light blue/green. Note these lines show a large number of crossed quotes (very unusual) in the first 6 minutes of trading.

7. Message rates for option quotes and trades color coded by reporting exchange. The spike is from AMEX just before it goes silent (a burst of zeroing out quotes).

8. Showing quote message rates from AMEX. You can clearly see the outage. See Chart 9 (below) for a close up of the spike just before the outage.

9. Close up of quote message rates from AMEX just before shutdown. This is what the red spike in Chart 8 (above) looks like, close up.These are zeroed quotes (bid/ask are 0) indicating a planned, orderly shutdown, and not a system failure.